High Rates? Are You Delirious?

By

Jason Zweig

Updated July 14, 2012 12:01 a.m. ET

Have today's insanely low interest rates driven investors insane?

Three closed-end funds offered by Cornerstone Advisors of Asheville, N.C., show that some investors have come to believe the impossible: that high yields can persist in a world where central banks have squashed down bond rates to next to nothing.

ENLARGE

Christophe Vorlet

These people have deluded themselves into believing they are earning fat yields. In reality, they merely are getting their own money back—and you can't turn a fantasy into fact just by wishing it were so.

At Cornerstone, investors are receiving "distribution yields" of roughly 22% of net asset value, and the shares trade for much more than the value of their underlying assets. According to the WSJ Market Data Group, the Cornerstone funds are the three highest-yielding of the 657 closed-end funds in the U.S.

Most of the yield at Cornerstone, however, doesn't come from its investments. In past years, it came from giving investors some of their original assets back. Now, it comes out of money the funds' investors have just added.

In each of the past five years, the Cornerstone Progressive Return fund distributed more than 10 times as much in dividends and other payouts as it earned in net investment income.

In 2008 and 2009, for example, 93% of total distributions were return of capital—giving shareholders their own money back (after subtracting the manager's fees, of course).

By the end of 2010, assets had shrunk to just $55 million from $132 million in 2007. At that rate, the fund would pay out its entire portfolio by 2014 or 2015—a kind of high-yield hara-kiri.

"If you keep throwing out more income than you can possibly make, someday your assets will go to zero," says Mariana Bush, a closed-end fund analyst at Wells Fargo Advisors. "And so will your management fees."

So, in 2011, the managers of Cornerstone Progressive Return raised $41 million in a "rights offering," a deal available only to existing investors that enabled them to buy one extra share for each three they already owned. That fresh capital injection helped the fund sustain its yield at more than 20%.

Last month, the fund raised $49 million in another rights offering. The prospectus says Cornerstone may turn around and pay much of that money back out to the same people who put it in.

Like a mutual fund, a closed-end fund is a pool of investments. But a closed end generally has a fixed number of shares, which trade on a stock exchange, where their prices can deviate from the underlying value of their holdings. Usually they trade below that value.

Most closed ends distribute varying amounts of dividends and capital gains. But roughly three dozen closed-end funds have "managed distributions" like Cornerstone's, seeking to pay out a flat rate of income regardless of market returns.

None comes close to Cornerstone's 20%-plus rates, which are "not reasonable or sustainable," according to Ms. Bush of Wells Fargo Advisors. And while rights offerings are fairly common, she says, they are "very unusual" among managed-distribution funds.

The magical payout machine at Cornerstone works roughly like this: Say you have $1,000 invested. You buy into the rights offering, shelling out another $250 or so to get extra shares. Cornerstone then pays out 20% or more in distributions, causing the value of each share to shrink accordingly.

The end result: You own more shares of a fund that is worth less, and most of the income you "earned" came from the money you put in yourself.

Cornerstone's prospectuses disclose that much of its payouts "will not represent yield or investment return on the fund's portfolio."

Still, Mike Taggart, an analyst at Morningstar, says he has received many emails from Cornerstone investors who believe that they are earning 20% yields and don't understand that these funds are simply giving them their own money back.

"People see the 'yields' on these funds and they jump in," he says, "and it makes me sick."

Regarding such a switcheroo as "income" is like making an interest-free loan and then telling yourself, as the debtor pays back only your principal, that you are earning a generous return on your money.

Cornerstone Progressive Return has 93% of its assets in the shares of other closed ends, many trading below the value of their assets. The largest holding, at 4.9%, is the Eaton Vance Tax-Managed Global Diversified Equity Income fund.

But while you could buy the Eaton Vance fund this week at a 14.3% discount to its net asset value, meaning that each $100 of its investments cost you less than $86, Cornerstone traded at a 10.3% premium. That means you had to pay $110 to get $100 in underlying assets.

That isn't all. Because most of its portfolio is in other funds that charge their own expenses, the effective annual costs at Cornerstone reach 2.5%, according to its prospectus—roughly double those of the typical closed end.

Investing has sunk to this: People are willing to pay a big premium for the privilege of getting their own money back, after fat fees, without interest—apparently because it gives them the illusion of earning a high yield.

Desperate people do desperate things. Investors who are starved for yield do desperately stupid things.

This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.